The Net Investment Income Tax and its Effect on Owners of Partnerships and S Corporations

In 2010, Congress enacted the Unearned Income Medicare Contribution Tax effective for years beginning in 2013. This tax is more commonly known as the Net Investment Income Tax (NIIT). Taxpayers paying estimated taxes based on projected 2013 income may have already felt the impact of this tax.

The NIIT is a 3.8% tax imposed on certain unearned income of 1040 filers, estates and trusts that have income above statutory threshold amounts. The thresholds for individuals are modified adjusted gross income above $200,000 for single and head of household taxpayers and $250,000 for married couples filing jointly ($125,000, if filing separately). The threshold for estates and trusts is the lowest dollar value in the highest tax bracket for the applicable tax year.

What is included in Net Investment Income (NII)? The Internal Revenue Code breaks it down by the following types of income:

Type 1 – Interest, dividends, annuities, royalties and rents, other than income derived from a trade or business not listed in type 2.
Type 2 – Income from passive activity businesses and businesses involved in trading financial instruments and commodities.
Type 3 – Taxable gains from the disposition of property held for investment, including the sale of a type 2 entity.

Owners of partnerships and S corporations are required to separately report passive income and losses when reporting taxable income because passive losses may not exceed passive income. The NII rules now also subject net passive income to the NIIT. The rules for determining passive/nonpassive status are applied at the owner, not the entity, level which can cause some owners to be subject to the passive activity rules and NII, while others are not. Passive activity rules and exceptions are complex, and should be discussed with a tax advisor.

Gain from the sale of passive interests in partnerships and S corporations are considered type 3 NII. In order to compute gain for the income tax, owners need to know their basis in the investment. This basis calculation can be tricky and, if not performed yearly, time consuming to determine. To calculate the correct gain to be used for NII purposes, the transferor owner must determine their passive status with regard to each of the entity’s activities.

If the taxpayer/owner is nonpassive with respect to at least one of the sold entity’s activities, they are eligible for a special NII gain/loss adjustment. Specific steps must be followed to calculate the adjustment on each nonpassive activity:

1. Calculate gain or loss on each of the entity’s properties as if each were sold for cash equal to the fair market value of the property. This is referred to as a deemed sale.
2. Determine the gain or loss per property by comparing the fair market value to the adjusted basis of the property.
3. Allocate gain or loss from the property to the interest disposed of by the seller. This value is your deemed sale gain.
4. Adjust your regular tax gain or loss by subtracting the deemed sale gain or adding the deemed sale loss. This gain/loss adjustment cannot exceed the regular tax gain or loss. A positive adjustment won’t create an NII gain. A negative adjustment can’t create an NII loss.
5. If your calculation results in an adjustment, a statement of adjustment must be attached to your return.

We did say this was complex! If you are an owner of a partnership or S corporation, please contact your trusted Marcum Tax Advisor for assistance.